Deutsche: Why Russia Should Be A Frontier Market

By Shuli Ren

Don’t wait for a geopolitical crisis or financial meltdown before realizing some countries are unsound. The Ukraine flare-up and the subsequent fall in MICEX only highlight the risks for investors in Russia, according to DeutscheBank strategist John-Paul Smith, who has been Underweight on the country for over three years.

This month, the MICEX has lost 14% of its market value. The iShares MSCI Russia Capped ETF (ERUS) lost 14.8%. The Market Vectors Russia ETF Trust (RSX) slumped 13.9%.

Smith argues Russia deserves a frontier market status, or a class of its own, not because of geopolitical risk. Rather, Russia faces a broad-based corporate governance issue: Enterprises forgo corporate profits at the bidding of the politicians.

The Deutsche strategist maps out his justifications. First, the concentration of economic power:

The concentration of the equity market into a relatively small number of names and the preponderance of state-controlled companies within these. The other BRIC markets also have a high proportion of state-controlled companies but have also seen a higher level of diversification over recent years.

A 2012 study by Troika Dialog Research showed that the Russian state owns 30% of the equity market, with another 30% owned by oligarchs and domestic “businessmen.” A new report published by Wealth-X today estimates Russia’s 10 richest men lost $6.6 billion since last Monday. For reference purposes, the ruble-denominated MICEX index lost about $60 billion market cap. Simply put, 10 men own over 10% of the equity wealth in Russia.

Second, Russian President Vladimir Putin uses corporations to advance his political interest. Here is Smith again:

The way in which the Russian state under Vladimir Putin has used listed companies as vehicles to help to achieve broader political, social and geopolitical goals. Gazprom is the most obvious example, but the listed state-controlled banks, in particular VTB, and to a lesser extent Sberbank, have also had to pursue what appears to be a broader state-led agenda with respect to certain aspects of their business, in particular to provide finance to key industries and individuals both in Russia and also in former CIS countries such as Ukraine.

Third, how about investors in the U.S.? They are minority shareholders and what happens when U.S.’s foreign policies are at odds with Russia?

The pursuit of foreign policy goals that appear to some extent inimical to those of the countries of origin of most overseas-based minority investors. The most obvious example is the US state pension funds, which in many instances have reduced exposure to their own equity market at the worst possible time, to put money into an asset class which has a relatively high weighting in companies controlled by the Russian and Chinese governments. These potentially conflicting foreign policy objectives also put investors at risk of becoming hostages of fortune to any potential financial sanctions pursued by either side in disputes such as the current one.

As a result, Russia’s state-owned companies are largely “uninvestable”, sending investors to rush into a few very crowded trades, argues Smith:

The consumer and service sectors generally fare better, but are underrepresented on the
equity market with the result that the few well-run listed consumer companies such as Magnit can command hefty valuation premiums, thereby imposing an entirely separate set of risks for investors who have crowded into a relatively narrow subset of stocks.

But now that political conflict is encroaching into the consumer economy, retail stocks are at risk too, according to a new report published by Deutsche Asset & Wealth Management today:

Russian equities will stay under pressure until political tensions ease. Most impacted will be the sectors with mostly domestic exposure like banks, retailers. Exporters, especially energy, will be relatively better due to weaker ruble and still high oil price. State controlled companies might come under more scrutiny or even sanctions from the West.

In March, Sberbank (SBER.RU) and VTB Bank (VTBR.RU) have lost a quarter of their market value; Gazprom (OGZPY), 15%; Mobile TeleSystems (MBT) lost 8.3% and VimpelCom (VIP), whose Uzbekistan unit is under SEC investigation, lost 16%. Yandex (YNDX) has slumped 22%. Magnit (MGNT-RU) has fallen 15%.

About Emerging Markets Daily

Emerging markets have been synonymous with growth, but the outlook for individual nations is constantly changing. Countries from Brazil and Russia to Turkey face challenges including infrastructure bottlenecks, credit issues and political shifts. Barrons.com’s Emerging Markets Daily blog analyzes news, data and research out of emerging markets beyond Asia to help readers navigate the investment landscape.

Barron’s veteran Dimitra DeFotis has been blogging about emerging market investing since traveling to India and Turkey. Based in New York, she previously wrote for Barron’s about U.S. equity investing, including cover stories and roundtables on energy themes. Dimitra was among the first digital journalists at the Chicago Tribune and started her career as a police reporter at the Daily Herald in the Chicago suburbs. Dimitra holds degrees from the University of Illinois and Columbia University, where she was a Knight-Bagehot Fellow in the business and journalism schools. She studies multiple languages and photography.